The brutal logic of index investing

Henry Cobbe shares his experience of developing index fund and ETF investment strategies.

This is the introduction to a series of articles by Henry Cobbe exploring the world of index investing, taken from his book How to Invest With Exchange-Traded Funds. Articles in the series will be published each Thursday.

Henry is head of research at Elston Consulting, which researches and develops investment strategies for asset owners, asset managers and intermediaries. After graduating in 1999 with a first-class MA (Hons) degree from the University of Edinburgh, he worked as a research analyst at leading investment managers, including Schroders plc, Thames River Capital LLP and was a partner at Nevsky Capital LLP. Henry is also a trustee of various private client and charitable trusts. Henry is an IMC holder since 2000, a CFA charter holder since 2004 and is author of How to Invest With Exchange-Traded Funds.

From space pens to pencils

There’s a famous story, probably an urban myth, about NASA spending millions of dollars of research to develop a space pen whose ink could still flow in a zero-gravity environment. When the Russians were asked whether they planned to respond to the challenge to enable their cosmonauts be able to write in space, they answered “We just use a pencil.”                    

Sometimes sensible and straightforward answers to problems prove more durable than more elaborate and costly alternatives.

The same could be said of investments. The quest for high-cost star managers in the hope of alchemy is under pressure from low-cost index funds that get the job done, by giving low-cost, transparent and liquid exposure to a particular asset class.

How an active stock-picker became a passive enthusiast

I spent my early years in the City working for active managers. My job was to pick stocks based on proprietary models of those companies’ operating and financial models. I was fortunate enough to work in a very successful hedge fund, whose style was “true active”: it could be highly concentrated on high-conviction stocks, it could be long or short on a stock or a market, it could (but didn’t) use leverage. If you enjoy stockpicking, as I did, working for a relatively unconstrained mandate was, at times, highly rewarding, at times highly stressful and always interesting.

Investors, typically large institutions, that wanted access to this strategy, had to have deep pockets to wear the very high minimum investment, and the fund was not always open for new investors. It certainly wasn’t available to the man on the street.

Knowledge gap entrenches disadvantage

When I started my own family and started investing in a Child Trust Fund, I became all too aware of the massive disconnect and difference between the investment opportunities open to hundreds of institutional investors and those available to millions of ordinary individual retail investors.

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I was staggered and rather depressed to see how few people in the UK harness the power of the markets to increase their long-term financial resilience. Of the 11 million ISA accounts held by 30 million working adult, only 2 million are Stocks and Shares ISAs. The investing public is a narrow audience. The vast majority of people are put off from learning/starting to invest by complexity, jargon and unfamiliarity.

Casual conversations with people from all walks of life showed that while they may fall prey to some scheme that promised unrealistic returns, they were less inclined to put a “boring” checklist in place to contribute to their own ISA or Junior ISA, perhaps unaware that this could be done for less than the cost of a coffee habit at £25 per month.

The lack of knowledge on investing was nothing to do with gender, age or education. It was almost universal. People either knew about investments or they didn’t. And that knowledge was usually hereditary. And it entrenches disadvantage.

Retail investments need a shake-up

Looking at the retail fund industry, it was clear that there wasn’t much that was truly “active” about it.  Most long-only retail managers hugged benchmarks for chunky fees that befitted their brand or status (now known as “closet indexing”). Until recently, the bulk of personal finance pages and investment journalism was more about a quest for a handful of “star managers”, in whatever asset class, who were ascribed the status of an alchemist, that investors would then herd towards. It seemed like the retail fund industry was focused on solving the wrong problem: on how to find the next star manager, rather than how to have a sensible, robust diversified portfolio.

By contrast, in the US, there has always been a higher culture of equity investing (New York cabbies talk more about stocks than about sport, in my experience). So I was fascinated to read about the behavioural science that underpinned the roll out of automatic enrolment in the US in 2005, where investors who were not engaged with their pension plan were defaulted into a Target Date Fund – a multi-asset index fund whose mix of assets change over time, according to their expected retirement date. I also read about the mushrooming of so-called ETF strategists, investment research firms that put together ultra-low cost managed portfolios for US financial advisers built entirely with exchange traded funds.

Winds of change

Conscious of these emerging trends, it seemed that mass-market investing in the UK was about to enter a period of structural change: namely with the ban of fund commissions (the Retail Distribution Review), and the launch of automatic enrolment, as well as other planned “behavioural finance” interventions to improve savings rates and financial capability.

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So in 2012, I set up my own research firm to see what, if any, of that experience in the US might apply in the UK. We work with asset managers to develop low-cost multi-asset investment strategies for the mass market, constructed with index-tracking funds and ETFs. It is bringing the rather dry science of institutional investing into the brand-rich and personality-heavy world of personal investing.

Why index investing?

I try and avoid the terms active and passive and will explain why. For most people, a multi-asset approach using index funds makes sense. This can be called “index investing”. Surprisingly, one of its biggest supporters is Warren Buffett. As Buffett wrote in his 2017 letter to shareholders: “Consistently buy a low cost…index fund. I think it’s the thing that makes the most sense practically all of the time...Keep buying through thick and thin, and especially through thin.”

In this series of articles for Interactive Investor, I share some of the experience I have had in developing investment strategies and products for asset managers built with index funds and ETFs. I look at the concepts underpinning multi-asset investing, focus on the importance of getting the asset allocation right for a given objective, summarise my view on the active vs passive debate (and attempt to clarify some terms), as well as offer some practical tips on building and managing your own portfolio.

Each of the articles can be explored more deeply in a book I wrote with my former colleague and co-author Shweta Agarwal: How to Invest with Exchange-Traded Funds: a practical guide for the modern investor.

Henry Cobbe is a freelance contributor and not a direct employee of interactive investor.